It is a stark reminder of how severe the perturbation to the world’s financial system was during and following the Global Financial Crisis that central bank interest rates in many leading economies are still at historic lows seven years or so after the worst of the storm hit.
The idea of dropping central bank interest rates is to stimulate the economy by making “cheap†money available to business in the hope that they will borrow to expand their activities and hence prime the economic pump. Of course, the headline central bank rates are only available to commercial banks and so the actual borrowing costs to businesses are higher, but still at historically low values. In the very uncertain climate stemming from the Global Financial Crisis, businesses have been reluctant to borrow whilst they remain unsure about demand which has been ubiquitously weak since the crisis (when compared to a normal post-recession recovery period). Additionally, the crisis showed that many banks were seriously over-exposed in the markets (the ration of assets held to loans outstanding was too low), so many banks soaked up additional capital to improve their balance sheets against a future financial disaster.
What happens from here?
As a consequence of these facts, a number of central banks indulged in quantitative easing whereby new money was created to purchase sovereign bonds and mortgage-backed securities in a bid to keep long-term (state) borrowing costs down and make consumer mortgages more affordable. The EU is set to embark upon its own QE program from Monday in a bid to stimulate the stuttering Eurozone economy. Investors like QE since it boosts value in stock markets as part of the injected capital gets invested in bonds and stocks – this is partly why some markets have recently hit fresh all-time high values. Any move to turn off QE measures (as the US did in the autumn) or raise borrowing costs sends the markets down.
The Federal Reserve in the USA has indicated that it remains flexible about when rates will start to move upwards. It noted that whilst the economy continues to strengthen, unemployment is still problematic with many Americans unemployed or underemployed and that wage growth (which is a driver for consumer demand) is sluggish. This has been interpreted to suggest that an interest hike before the summer is unlikely. It sent the Dollar lower (transiently, at least) and markets higher, but rates must rise at some stage. However, the major driver towards higher rates is inflation and with falling energy prices and weak global demand US inflation is currently low.
